CIBC's Mally: junk market rebound will depend on the Three E's

By Paul Deckelman

New York, Oct. 17 - There's nothing really wrong with the high-yield market that couldn't be fixed by a good, healthy dose of the Three E's - equity, earnings and economy. That, essentially, is the view of Edward P. Mally, the head of high yield research for CIBC World Markets Corp., who says the high-yield market's ability to come back from its recent doldrums will depend on the equity markets being able to build on the nascent rally that they've had over the past week or so, as well as an environment of mostly positive corporate earnings and a good economic environment.

Mally also believes that the high-yield new issuance sector will best be helped by the emergence of a big, high-profile deal that will attract investor interest, price well and trade well in the secondary market (see related story).

In a wide-ranging interview with Prospect News earlier this week at the investment bank's midtown Manhattan offices, Mally, who also holds the rank of managing director of CIBC's Leveraged Finance Group, commented that for the currently struggling junk market to get back to even the kind of modest upturn that was seen in the first half of the year "I think you need a number of different things in some sort of combination. One is going to be having a firmer tone in the equity markets. For high yield, the equity market is important because it has certain implications for the underlying asset value."

This week and last, the stock market has mostly been strongly on the upside, after a seven-week losing streak that battered equities down to levels unseen since the late 1980s. While high-yield prices have been generally firmer in line with the better tone in stocks, there doesn't seem to have been any huge rush in the junk pits to hop aboard the bullish bandwagon.

"I think what we're seeing in the equity markets is those markets reacting in anticipation of third-quarter earnings reports coming out favorably," Mally said.

"At this point, when I look at the relationship between price action in the equity markets and price action in the high-yield market, the high-yield market right now appears to be lagging. While it has shown a positive trend in the last three days [as of mid-week], probably up an average of two to three points, there's still a significant amount of ground to retrace in high yield. But obviously the correlation between equities and high yield would point to positive things in high yield, given the upward move in equity prices."

The second ingredient needed for any kind of a junk bounce is "a firm positive tone for earnings," something which has emerged to some degree in recent days, with a considerably improved tone compared with the weak earnings posted in the second calendar quarter and reported around the beginning of the summer.

Corporate earnings, said Mally "are just as an important factor in this... Until we see a firm consensus about the direction of corporate earnings, there will continue to be a cautiousness that is all over the high-yield market itself."

Mally sees this wary tone prevalent in both the secondary market and on the primary side as well. "When I think about the attitude of investors right now, I still see a focus on 'I'm looking for value in the secondary market,' and to some extent, concern around the possibility of a heavy new-issue calendar and maybe some skepticism about the quality of deals in the marketplace."

He noted that while slightly more than $50 billion of new issuance has been seen so far this year, more than $5 billion of potential new issues "have been postponed, cancelled or otherwise withdrawn. I think that is a significant quantity of issues that have not been priced this year."

Besides the equity upturn and a bounce-back in corporate earnings - each of which seems to be under way - the CIBC research chief said the third leg of the trifecta needed to really bring junk back would have to be a consistent positive economic environment.

"At this point, we're at a crossroads where there's still plenty of uncertainty - obviously there's a lingering uncertainty as to when or if a Gulf War II occurs, and if and when that happens, the duration of it and the impact on oil prices and the economy."

But while all three are needed, the equity upturn holds the key.

In what had been the recent environment of struggling stocks and Treasury yields falling to historic lows, one might think that high yield would have emerged as a preferred alternate investment vehicle for investors scared of the equity market meltdown but willing to tolerate somewhat more risk to improve on the returns offered by the government bonds.

But Mally said that while some money may have found its way into junk via that route, "then again, if you look at an environment of low Treasury rates, which implies low economic growth, and a sluggish stock market, I think on balance it is more difficult for investors to have a high degree of confidence in the high-yield asset class.

"What you may actually see in that scenario [stocks continuing to struggle as Treasury yields remain low] is more a gravitation to the crossover credits."

Indeed, he noted, "when you look at the secondary market now, what seems to have a strong influence on high yield is the incursion of the crossovers. When you see the likes of, most recently, Ford Motor Co. moving to high yield-type trading levels [Ford bonds were recently trading at junk-like yields in the 9%-to-10% area despite the auto giant's still solidly investment-grade ratings], names like that begin to capture more and more of the attention of high-yield investors, and in my opinion that's the cause of some re-allocation of some cash to the crossover market."

The crossover boom did not start with the nosedive seen in Ford shares and bonds after another investment house released critical commentary about the Number-Two U.S. carmaker. "We've seen that type of thing throughout the year," Mally said, noting that WorldCom Inc., for instance, "was a big source of crossover activity earlier in the year" as the Clinton, Miss.-based telecom giant slid into bankruptcy. "That turned out to be not a happy experience for investors," Mally said drily.

At the same time, though, he said some high-yield players were moving out of pure junk and into automotive-related crossover names, "Ford most recently, but throughout the year everything from Meritor to Dana Corp. to Goodyear to Cummins Engine has moved toward high-yield ratings and/or high-yield trading levels" (Cummins was fully lowered to junk rating levels just this week).

"Just looking at that as one specific set of examples, that's a part of the market that in a way brings its own source of new supply into high yield, or at least a source of supply that captures attention, or competes for the attention of portfolio managers and their money."

While the crossovers seem to have been active as equities struggled and Treasuries boomed, should the current equity upturn prove to be the real thing and should the bulls then stampede back to Wall Street in force after the lengthy correction the market has undergone for most of the past two years, there's always the danger that a too-healthy equity market might simply suck investor dollars out of a junk market which might not be able to compete with the kind of returns that stocks offer.

It happened during the late 1990s - seemingly several lifetimes ago - when the big tech and telecom boom that was then underway drove the stock indices, particularly the Nasdaq, to unheard-of peak levels and produced unprecedented percentage gains for some sectors in the high double-digits, far outstripping the normally very respectable returns north of 10% that high yield was able to produce at that time.

But Mally, in projecting that a stronger stock market would help to lift junk, isn't worried that a revived stock market would strangle the fragile junk gains. He declared that "ultimately, having a strong equity market and the implications which that has for a strong economy and the underlying asset values in high yield is more important to the health of high yield, and a stronger equity market on the balance has a positive impact. Even if we saw some cash being redirected to equities, I think that the ability of a favorable equity market to boost confidence in the high-yield market, on the whole, will portend well for the high-yield asset class."

He said that CIBC is "looking to add value for investors. We're focusing on situational trading opportunities, more distressed, fallen angel and crossover" credits.

Amid the currently dicey market conditions, "we're looking at the higher quality credits, at the crossover credits. We're playing things more conservatively, to avoid volatility in what is still an uncertain market environment."

By industry, he said: "I think the best opportunities right now are in areas such as gaming, consumer products and certain segments of media, such as publishing. I also think the higher quality names in oil and gas, in energy exploration and production are a good place to put money to work."

Looking at the once high-flying telecom sector, now in the throes of an extended meltdown, Mally predicted that "the scenario where there are some companies that survive is a likely scenario, like Nextel and Level 3 Communications, to cite a couple of examples. They will play in what will increasingly become the telecom niche rather than a sector. Many - probably most - of the companies that have filed for bankruptcy, in my opinion will likely go away from a high yield perspective," with their bonds cancelled or exchanged for equity as they undergo reorganization (a scenario seen just this week when the former Williams Communications Group Inc. emerged from Chapter 11 as an essentially debt-free entity known as WilTel).

"From a business perspective, assets [of the junk telecommers being reorganized through bankruptcy] will be absorbed into other companies. Might there be some repeat high-yield issuance from some of those new combinations? Sure, there might be," he allowed. "But I think to see these companies emerge from bankruptcy and come back to the high-yield market is a highly unlikely scenario. Their business plans will now have to be financed with equity rather than with debt."

In recent weeks and months, the utility, energy trading and merchant energy generating sector has replaced the faded telecom constellation as the troubled area of interest in the junk market, as the bonds of such formerly investment-grade rated entities as Dynegy Inc., Williams Cos., Mirant Corp. and, most recently, Allegheny Electric Inc. have slid into junkbond land beside such names as AES Corp., Calpine Corp, and CMS Energy Corp. Meanwhile, other once-secure names such as TXU Corp. and American Electric Power, to name two, have traded down to junk-like levels.

Mally said whether the utilities manage to survive their current problems "is going to be a function of how their operations continue to perform [in order to service the companies' debt] and what their liquidity and access to capital resources will be.

He said: "I wouldn't be surprised to see some of those other companies be downgraded to below investment grade, while I'm sure that [still] others will manage to stay investment grade.

Could some of the companies now struggling with collapsed wholesale electricity prices, upcoming debt maturities, lowered equity prices and reduced access to the capital markets make the trip all the way down to default?

"Sure," said Mally. "As long as there's a credit crunch in the sector, things could get worse. Credit crunches always come at a bad time for an industry - and a bad time for the financial markets."

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